CHAPTER ONE

BEHAVIOURAL FOUNDAIONS: THEORIES OF CONSUMPTON

Introduction
How do households decide how much of their income to consume today and how much to save
for the future? This is a microeconomic question because it addresses the behavior of individual
decision makers. Yet its answer has important macroeconomic consequences. As we have seen
in Macroeconomics I, households’ consumption decisions affect the way the economy as a whole
behaves both in the long run and in the short run. The consumption decision is crucial for long-
run analysis because of its role in economic growth. The saving rate measures how much of its
income the present generation is not consuming but is instead putting aside for its own future and
for future generations.

The consumption decision is crucial for short-run analysis because of its role in determining
aggregate demand. Consumption has high share of GDP, so fluctuations in consumption are a
key element of booms and recessions. The IS–LM model shows that changes in consumers’
spending plans can be a source of shocks to the economy and that the marginal propensity to
consume is a determinant of the fiscal-policy multipliers.

In macroeconomics I, we have explained consumption with a function that relates consumption

to disposable income: C = C(Y − T). This approximation allowed us to develop simple models
for long-run and short-run analysis, but it is too simple to provide a complete explanation of
consumer behavior.

Since macroeconomics began as a field of study, many economists have written about the theory
of consumer behavior and suggested alternative ways of interpreting the data on consumption
and income. This chapter thoroughly presents the views of various prominent economists to
show the diverse approaches to explaining consumption.

1.1 . John Maynard Keynes and the Consumption Function

We begin our study of consumption with John Maynard Keynes’s General Theory, which was
published in 1936. Keynes made the consumption function central to his theory of economic
fluctuations, and it has played a key role in macroeconomic analysis ever since. Let’s consider
what Keynes thought about the consumption function and then see what puzzles arose when his
ideas were confronted with the data.

Brainstorming Question: What does it mean when we say consumption? How can say your monthly
consumption correlated with your monthly income? Explain it in terms of direction.

The Three Keynes’s Conjectures

Today, economists who study consumption rely on sophisticated techniques of data analysis.
With the help of computers, they analyze aggregate data on the behavior of the overall economy
from the national income accounts and detailed data on the behavior of individual households
from surveys. Because Keynes wrote in the 1930s, however, he had neither the advantage of
these data nor the computers necessary to analyze such large data sets. Instead of relying on
statistical analysis, Keynes made conjectures about the consumption function based on
introspection and casual observation.

First and most important, Keynes conjectured that the marginal propensity to consume —the
amount consumed out of an additional dollar of income —is between zero and one. He wrote
that the ―fundamental psychological law, upon which we are entitled to depend with great
confidence, . . . is that men are disposed, as a rule and on the average, to increase their
consumption as their income increases, but not by as much as the increase in their income.’’ That
is, when a person earns an extra dollar, he typically spends some of it and saves some of it. When
we developed the Keynesian cross, the marginal propensity to consume was crucial to Keynes’s
policy recommendations for how to reduce widespread unemployment. The power of fiscal
policy to influence the economy—as expressed by the fiscal-policy multipliers—arises from the
feedback between income and consumption. Second, Keynes posited that the ratio of
consumption to income, called the average propensity to consume, falls as income rises. He
believed that saving was a luxury, so he expected the rich to save a higher proportion of their
income than the poor. Although not essential for Keynes’s own analysis, the postulate that the
average propensity to consume falls as income rises became a central part of early Keynesian
economics.
Third, Keynes thought that income is the primary determinant of consumption and that the
interest rate does not have an important role. This conjecture stood in stark contrast to the beliefs
of the classical economists who preceded him. The classical economists held that a higher
interest rate encourages saving and discourages consumption. Keynes admitted that the interest
rate could influence consumption as a matter of theory. Yet he wrote that ―the main conclusion
suggested by experience, I think, is that the short-period influence of the rate of interest on
individual spending out of a given income is secondary and relatively unimportant.’’

On the basis of these three conjectures, the Keynesian consumption function is often written as
C = C− + cY, C −
> 0, 0 < c < 1, where C is consumption, Y is disposable income, C− is a
constant, and c is the marginal propensity to consume. This consumption function, shown in
Figure 1.1, is graphed as a straight line. C− determines the intercept on the vertical axis, and c
determines the slope.

Notice that this consumption function exhibits the three properties that Keynes posited. It
satisfies Keynes’s first property because the marginal propensity to consume c is between zero
and one, so that higher income leads to higher consumption and also to higher saving. This
consumption function satisfies Keynes’s second property because the average propensity to
consume APC is APC = C/Y = C−/Y + c. As Y rises, C-/Y fall, and so the average propensity to
consume C/Y falls. And finally, this consumption function satisfies Keynes’s third property
because the interest rate is not included in this equation as a determinant of consumption.

Activity: I think now you have got enough knowledge to answer the following questions.
Once you attempt, if you find any difficulty, please refer back for the detail interpretation.
1. List and explain the three consumption conjectures of Keynes?
2. What will happen on APC if say interest rate is included as a determinant of consumption in
the Keynes equation?

The Early Empirical Successes

Soon after Keynes proposed the consumption function, economists began collecting and
examining data to test his conjectures. The earliest studies indicated that the Keynesian
consumption function was a good approximation of how consumers behave. In some of these
studies, researchers surveyed households and collected data on consumption and income. They
found that households with higher income consumed more, which confirms that the marginal
propensity to consume is greater than zero. They also found that households with higher income
saved more, which confirms that the marginal propensity to consume is less than one. In
addition, these researchers found that higher-income households saved a larger fraction of their
income, which confirms that the average propensity to consume falls as income rises.

Fig. 1.1 The Keynesian Consumption Function

Thus, these data verified Keynes’s conjectures about the marginal and average propensities to
consume. In other studies, researchers examined aggregate data on consumption and income for
the period between the two world wars. These data also supported the Keynesian consumption
function. In years when income was unusually low, such as during the depths of the Great
Depression, both consumption and saving were low, indicating that the marginal propensity to
consume is between zero and one. In addition, during those years of low income, the ratio of
consumption to income was high, confirming Keynes’s second conjecture. Finally, because the
correlation between income and consumption was so strong, no other variable appeared to be
important for explaining consumption. Thus, the data also confirmed Keynes’s third conjecture
that income is the primary determinant of how much people choose to consume.
Secular Stagnation, Simon Kuznets, and the Consumption Puzzle
Although the Keynesian consumption function met with early successes, two anomalies soon
arose. Both concern Keynes’s conjecture that the average propensity to consume falls as income
rises.

The first anomaly became apparent after some economists made a dire —and, it turned out,
erroneous —prediction during World War II. On the basis of the Keynesian consumption
function, these economists reasoned that as incomes in the economy grew over time, households
would consume a smaller and smaller fraction of their incomes. They feared that there might not
be enough profitable investment projects to absorb all this saving. If so, the low consumption
would lead to an inadequate demand for goods and services, resulting in a depression once the
wartime demand from the government ceased. In other words, on the basis of the Keynesian
consumption function, these economists predicted that the economy would experience what they
called secular stagnation —a long depression of indefinite duration —unless the government
used fiscal policy to expand aggregate demand.

Fortunately for the economy, but unfortunately for the Keynesian consumption function, the end
of World War II did not throw the country into another depression. Although incomes were
much higher after the war than before, these higher incomes did not lead to large increases in the
rate of saving. Keynes’s conjecture that the average propensity to consume would fall as income
rose appeared not to hold.

The second anomaly arose when economist Simon Kuznets constructed new aggregate data on
consumption and income dating back to 1869. Kuznets assembled these data in the 1940s and
would later receive the Nobel Prize for this work. He discovered that the ratio of consumption to
income was remarkably stable from decade to decade, despite large increases in income over the
period he studied. Again, Keynes’s conjecture that the average propensity to consume would fall
as income rose appeared not to hold.

Activity: Now answer these questions!

1. Is there any occasion of decrement of investment while saving is increased? Explain with
empirical evidences.
2. Could you explain on how Kuznet disproves the long run postulates of Keynes conjectures?
The failure of the secular-stagnation hypothesis and the findings of Kuznets both indicated that
the average propensity to consume is fairly constant over long periods of time. This fact
presented a puzzle that motivated much of the subsequent research on consumption. Economists
wanted to know why some studies confirmed Keynes’s conjectures and others refuted them. That
is, why did Keynes’s conjectures hold up well in the studies of household data and in the studies
of short time-series but fail when long time-series were examined? Figure 1.2 illustrates the
puzzle. The evidence suggested that there were two consumption functions. For the household
data and for the short time-series, the Keynesian consumption function appeared to work well.
Yet for the long time-series, the consumption function appeared to exhibit a constant average
propensity to consume. In Figure 1.2, these two relationships between consumption and income
are called the short-run and long-run consumption functions. Economists needed to explain how
these two consumption functions could be consistent with each other.

In the 1950s, Franco Modigliani and Milton Friedman each proposed explanations of these
seemingly contradictory findings. Both economists later won Nobel Prizes, in part because of
their work on consumption.

Fig. 1.2 The Consumption Puzzle

Now it is time to see how Modigliani and Friedman tried to solve the consumption puzzle. Both
Modigliani’s life-cycle hypothesis and Friedman’s permanent-income hypothesis rely on the
theory of consumer behavior proposed much earlier by Irving Fisher.

1.2 Ando-Modigliani and the Life-Cycle Hypothesis

In a series of papers written in the 1950s, Franco Modigliani and his collaborators Albert Ando
and Richard Brumberg used Fisher’s model of consumer behavior to study the consumption
function. One of their goals was to solve the consumption puzzle —that is, to explain the
apparently conflicting pieces of evidence that came to light when Keynes’s consumption
function was confronted with the data. According to Fisher’s model, consumption depends on a
person’s lifetime income. Modigliani emphasized that income varies systematically over
people’s lives and that saving allows consumers to move income from those times in life when
income is high to those times when it is low. This interpretation of consumer behavior formed
the basis for his life-cycle hypothesis.

The Hypothesis
One important reason that income varies over a person’s life is retirement. Most people plan to
stop working at about age 65, and they expect their incomes to fall when they retire. Yet they do
not want a large drop in their standard of living, as measured by their consumption. To maintain
their level of consumption after retirement, people must save during their working years. Let’s
see what this motive for saving implies for the consumption function. Consider a consumer who
expects to live another T years, has wealth of W, and expects to earn income Y until s/he retires R
years from now. What level of consumption will the consumer choose if she wishes to maintain a
smooth level of consumption over her life?

The consumer’s lifetime resources are composed of initial wealth W and lifetime earnings of R ×
Y. (For simplicity, we are assuming an interest rate of zero; if the interest rate were greater than
zero, we would need to take account of interest earned on savings as well.) The consumer can
divide up her lifetime resources among her/his T remaining years of life. We assume that s/he
wishes to achieve the smoothest possible path of consumption over her lifetime. Therefore, s/he
divides this total of W + RY equally among the T years and each year consumes C = (W + RY)/T.
We can write this person’s consumption function as C = (1/T)W + (R/T)Y.
For example, if the consumer expects to live for 50 more years and work for 30 of them, then T=
50 and R = 30, so her consumption function is C = 0.02W + 0.6Y.

This equation says that consumption depends on both income and wealth. An extra $1 of income
per year raises consumption by $0.60 per year, and an extra $1 of wealth raises consumption by
$0.02 per year. If every individual in the economy plans consumption like this, then the
aggregate consumption function is much the same as the individual one. In particular, aggregate
consumption depends on both wealth and income. That is, the economy’s consumption function
is C = aW + bY, where the parameter a is the marginal propensity to consume out of wealth, and
the parameter b is the marginal propensity to consume out of income.

Activity: Now let you live for more 60 years, and work for 40 years, then set your consumption
function? What will happen on your consumption if your income increases by one unit?

Implications
Figure 1.3 graphs the relationship between consumption and income predicted by the life-cycle
model. For any given level of wealth W, the model yields a conventional consumption function
similar to the one shown in Figure 1.1.

Notice, however, that the intercept of the consumption function, which shows what would
happen to consumption if income ever fell to zero, is not a fixed value, as it is in Figure 1.1.
Instead, the intercept here is aW and, thus, depends on the level of wealth.

This life-cycle model of consumer behavior can solve the consumption puzzle. According to the
life-cycle consumption function, the average propensity to consume is C/Y = a(W/Y) + b.
Because wealth does not vary proportionately with income from person to person or from year to
year, we should find that high income corresponds to a low average propensity to consume when
looking at data across individuals or over short periods of time. But over long periods of time,
wealth and income grow together, resulting in a constant ratio W/Y and thus a constant average
propensity to consume.
Fig. 1.3 The Life Cycle Consumption Function

To make the same point somewhat differently, consider how the consumption function changes
over time. As Figure 1.3 shows, for any given level of wealth, the life-cycle consumption
function looks like the one Keynes suggested. But this function holds only in the short run when
wealth is constant. In the long run, as wealth increases, the consumption function shifts upward,
as in Figure 1.4. This upward shift prevents the average propensity to consume from falling as
income increases. In this way, Modigliani resolved the consumption puzzle posed by Simon
Kuznets’s data. The life-cycle model makes many other predictions as well. Most important, it
predicts that saving varies over a person’s lifetime. If a person begins adulthood with no wealth,
s/he will accumulate wealth during her/his working years and then run down her/his wealth
during her/his retirement years. Figure 1.5 illustrates the consumer’s income, consumption, and
wealth over her/his adult life. According to the life-cycle hypothesis, because people want to
smooth consumption over their lives, the young who are working save, while the old who are
retired dissave.

Activity:
Explain how Modigliani resolved the consumption puzzle posed by Simon Kuznets’s?
Case Study: The Consumption and Saving of the Elderly
Many economists have studied the consumption and saving of the elderly. Their findings present
a problem for the life-cycle model. It appears that the elderly do not dissave as much as the
model predicts. In other words, the elderly do not run down their wealth as quickly as one would
expect if they were trying to smooth their consumption over their remaining years of life. There
are two chief explanations for why the elderly do not dissave to the extent that the model
predicts. Each suggests a direction for further research on consumption.

Fig. 1.4 Impact of Wealth Change on Consumption

Fig. 1.5 Consumption, Income and Wealth over the Life Cycle

The first explanation is that the elderly are concerned about unpredictable expenses. Additional
saving that arises from uncertainty is called precautionary saving. One reason for precautionary
saving by the elderly is the possibility of living longer than expected and thus having to provide
for a longer than average span of retirement. Another reason is the possibility of illness and large
medical bills. The elderly may respond to this uncertainty by saving more in order to be better
prepared for these contingencies. The precautionary-saving explanation is not completely
persuasive, because the elderly can largely insure against these risks. To protect against
uncertainty regarding life span, they can buy annuities from insurance companies. For a fixed
fee, annuities offer a stream of income that lasts as long as the recipient lives. Uncertainty about
medical expenses should be largely eliminated by Medicare, the government’s health insurance
plan for the elderly, and by private insurance plans.

The second explanation for the failure of the elderly to dissave is that they may want to leave
bequests to their children. Economists have proposed various theories of the parent–child
relationship and the bequest motive.

Activity: Are you interested to save more at your elderly age or at the old age? Why? Compare
your answer with the above description.
Overall, research on the elderly suggests that the simplest life-cycle model cannot fully
explain consumer behavior. There is no doubt that providing for retirement is an important
motive for saving, but other motives, such as precautionary saving and bequests, appear
important as well.

1.3 Milton Friedman and the Permanent-Income Hypothesis

In a book published in 1957, Milton Friedman proposed the permanent-income hypothesis to
explain consumer behavior. Friedman’s permanent-income hypothesis complements
Modigliani’s life-cycle hypothesis: both use Irving Fisher’s theory of the consumer to argue that
consumption should not depend on current income alone. But unlike the life-cycle hypothesis,
which emphasizes that income follows a regular pattern over a person’s lifetime, the permanent-
income hypothesis emphasizes that people experience random and temporary changes in their
incomes from year to year.

The Hypothesis
Friedman suggested that we view current income Y as the sum of two components, permanent
income YP and transitory income YT. That is, Y=YP +YT. Permanent income is the part of income
that people expect to persist into the future. Transitory income is the part of income that people
do not expect to persist. Put differently, permanent income is average income, and transitory
income is the random deviation from that average.

To see how we might separate income into these two parts, consider these examples:
 Mahlet, who has a law degree, earned more this year than Tolcha, who is a high-school
dropout. Mahlet’s higher income resulted from higher permanent income, because her
education will continue to provide her a higher salary.
 Shewit, an orange grower, earned less than usual this year because a freeze destroyed her
crop. Bahre, a California orange grower, earned more than usual because the freeze in
Florida drove up the price of oranges.

Bahre’s higher income resulted from higher transitory income, because he is no more likely than
Shewit to have good weather next year. These examples show that different forms of income
have different degrees of persistence. A good education provides a permanently higher income,
whereas good weather provides only transitorily higher income. Although one can imagine
intermediate cases, it is useful to keep things simple by supposing that there are only two kinds
of income: permanent and transitory.

Friedman reasoned that consumption should depend primarily on permanent income, because
consumers use saving and borrowing to smooth consumption in response to transitory changes in
income. For example, if a person received a permanent raise of $10,000 per year, his
consumption would rise by about as much. Yet if a person won $10,000 in a lottery, he would
not consume it all in one year. Instead, he would spread the extra consumption over the rest of
his life.

Assuming an interest rate of zero and a remaining life span of 50 years, consumption would rise
by only $200 per year in response to the $10,000 prize. Thus, consumers spend their permanent
income, but they save rather than spend most of their transitory income. Friedman concluded that
we should view the consumption function as approximately C= aYP, where a is a constant that
measures the fraction of permanent income consumed. The permanent-income hypothesis, as
expressed by this equation, states that consumption is proportional to permanent income.

Activity:

If you are permanent employee of government and let you gone to somewhere else
and the office paid you a daily professional fee for conducting the task. In which
type of income did you categorize it?
Do you think that transitory changes in taxes will have an effect on consumption
and aggregate demand?

Implications
The permanent-income hypothesis solves the consumption puzzle by suggesting that the standard
Keynesian consumption function uses the wrong variable. According to the permanent-income
hypothesis, consumption depends on permanent income YP; yet many studies of the consumption
function try to relate consumption to current income Y. Friedman argued that this errors-in-
variables problem explains the seemingly contradictory findings. Let’s see what Friedman’s
hypothesis implies for the average propensity to consume. Divide both sides of his consumption
function by Y to obtain APC =C/Y =aYP/Y.

According to the permanent-income hypothesis, the average propensity to consume depends on

the ratio of permanent income to current income. When current income temporarily rises above
permanent income, the average propensity to consume temporarily falls; when current income
temporarily falls below permanent income, the average propensity to consume temporarily rises.
Now consider the studies of household data. Friedman reasoned that these data reflect a
combination of permanent and transitory income. Households with high permanent income have
proportionately higher consumption. If all variation in current income came from the permanent
component, the average propensity to consume would be the same in all households. But some of
the variation in income comes from the transitory component, and households with high
transitory income do not have higher consumption. Therefore, researchers find that high-income
households have, on average, lower average propensities to consume.

Similarly, consider the studies of time-series data. Friedman reasoned that year-to-year
fluctuations in income are dominated by transitory income. Therefore, years of high income
should be years of low average propensities to consume. But over long periods of time—say,
from decade to decade —the variation in income comes from the permanent component. Hence,
in long time-series, one should observe a constant average propensity to consume, as in fact
Kuznets found. STDY

1.4 Robert Hall and the Random-Walk Hypothesis

The permanent-income hypothesis is based on Fisher’s model of intertemporal choice. It builds
on the idea that forward-looking consumers base their consumption decisions not only on their
current income, but also on the income they expect to receive in the future. Thus, the permanent-
income hypothesis highlights that consumption depends on people’s expectations.

Recent study on consumption has combined this view of the consumer with the assumption of
rational expectations. The rational-expectations assumption states that people use all available
information to make optimal forecasts about the future. This assumption can have profound
implications for the costs of stopping inflation. It can also have profound implications for the
study of consumer behavior.
The Hypothesis
The economist Robert Hall was the first to derive the implications of rational expectations for
consumption. He showed that if the permanent-income hypothesis is correct, and if consumers
have rational expectations, then changes in consumption over time should be unpredictable.
When changes in a variable are unpredictable, the variable is said to follow a random walk.
According to Hall, the combination of the permanent-income hypothesis and rational
expectations implies that consumption follows a random walk.

Hall reasoned as follows. According to the permanent-income hypothesis, consumers face

fluctuating income and try their best to smooth their consumption over time. At any moment,
consumers choose consumption based on their current expectations of their lifetime incomes.
Over time, they change their consumption because they receive news that causes them to revise
their expectations.

For example, a person getting an unexpected promotion increases consumption, whereas a

person getting an unexpected demotion decreases consumption. In other words, changes in
consumption reflect ―surprises‖ about lifetime income. If consumers are optimally using all
available information, then they should be surprised only by events that were entirely
unpredictable. Therefore, changes in their consumption should be unpredictable as well.

Activity:
1. According to Robert Hall when did a random walk in consumption happen?
2. How can an individual’s expectation matter for consumption?

Implications
The rational-expectations approach to consumption has implications not only for forecasting, but
also for the analysis of economic policies. If consumers obey the permanent-income hypothesis
and have rational expectations, then only unexpected policy changes influence consumption.
These policy changes take effect when they change expectations. For example, suppose that
today Congress passes a tax increase to be effective next year. In this case, consumers receive the
news about their lifetime incomes when Congress passes the law (or even earlier if the law’s
passage was predictable). The arrival of this news causes consumers to revise their expectations
and reduce their consumption. The following year, when the tax hike goes into effect,
consumption is unchanged because no news has arrived.

Hence, if consumers have rational expectations, policymakers influence the economy not only
through their actions but also through the public’s expectation of their actions. Expectations,
however, cannot be observed directly. Therefore, it is often hard to know how and when changes
in fiscal policy alter aggregate demand.

Case Study: Do predictable changes in income lead to predictable changes in consumption?

Of the many facts about consumer behavior, one is impossible to dispute: income and
consumption fluctuate together over the business cycle. When the economy goes into a recession,
both income and consumption fall, and when the economy booms, both income and consumption
rise rapidly.

By itself, this fact doesn’t say much about the rational-expectations version of the permanent-
income hypothesis. Most short-run fluctuations are unpredictable. Thus, when the economy goes
into a recession, the typical consumer is receiving bad news about his lifetime income, so
consumption naturally falls. And when the economy booms, the typical consumer is receiving
good news, so consumption rises. This behavior does not necessarily violate the random-walk
theory that changes in consumption are impossible to forecast.

Yet suppose we could identify some predictable changes in income. According to the random-
walk theory, these changes in income should not cause consumers to revise their spending plans.
If consumers expected income to rise or fall, they should have adjusted their consumption
already in response to that information. Thus, predictable changes in income should not lead to
predictable changes in consumption.

Data on consumption and income, however, appear not to satisfy this implication of the random-
walk theory. When income is expected to fall by $1, consumption will on average fall at the same
time by about $0.50. In other words, predictable changes in income lead to predictable changes
in consumption that are roughly half as large.

Why is this so? One possible explanation of this behavior is that some consumers may fail to
have rational expectations. Instead, they may base their expectations of future income
excessively on current income. Thus, when income rises or falls (even predictably), they act as if
they received news about their lifetime resources and change their consumption accordingly.
Another possible explanation is that some consumers are borrowing-constrained and, therefore,
base their consumption on current income alone. Regardless of which explanation is correct,
Keynes’s original consumption function starts to look more attractive. That is, current income
has a larger role in determining consumer spending than the random-walk hypothesis suggests.

Concluding Remarks
In the work of six prominent economists, we have seen a progression of views on consumer
behavior. Keynes proposed that consumption depends largely on current income. Since then,
economists have argued that consumers understand that they face an intertemporal decision.
Consumers look ahead to their future resources and needs, implying a more complex
consumption function than the one Keynes proposed. Keynes suggested a consumption function
of the form consumption =f(current income).

Recent work suggests instead that consumption=f(current income, wealth, expected future
income, interest rates). In other words, current income is only one determinant of aggregate
consumption.

Economists continue to debate the importance of these determinants of consumption. There

remains disagreement about, for example, the influence of interest rates on consumer spending,
the prevalence of borrowing constraints, and the importance of psychological effects.
Economists sometimes disagree about economic policy because they assume different
consumption functions. For instance, the debate over the effects of government debt is in part a
debate over the determinants of consumer spending. The key role of consumption in policy
evaluation is sure to maintain economists’ interest in studying consumer behavior for many years
to come.